Collateral quality is key

Many pension funds stopped their securities lending programmes last year, particularly after the collapse of Lehman Brothers. One year on, has this changed? This month's Off The Record survey looked at how pension funds approach securities lending.

Just over 37% of the pension fund respondents currently undertake securities lending. Income generation was named as the main reason for taking part in it, whereas the risk/reward ratio was cited as the argument for not doing it.

"We did it in the past but cancelled the agreement mainly due to very poor returns," explained one German scheme.

While seven schemes had no specific policies or restrictions in place for securities lending, others did, particularly with regard to the collateral.

"No cash collateral, only government bonds from the G8 as collateral, and only high value trades, no general collateral," said one Dutch pension fund.

"We will only accept government bonds as collateral and 50% only of the eligible holdings is to be lent," added a UK fund.

The respondents were split with regard to the implementation of emergency policies on securities lending during last year's banking crisis.

A slight majority of 27 respondents - 52% - did not introduce any emergency measures, compared with just over 48% that did. The measures mainly consisted of temporary suspension of the lending programme, restrictions on cash outrights and increasing the quality of collateral.

"[We] stopped lending to review the activity and then tightened the collateral to only accept government bonds, and restarted," explained one UK fund.

Three respondents said the emergency measures had now been lifted, while six still had them in place. A Dutch plan has partially lifted those emergency policies. "We keep balances on loan now," it said.

The majority of the 19 respondents - over 69% - that have interest rate or inflation swaps in place post collateral daily. Two respondents post it weekly, while intra-day, monthly and quarterly posting respectively took place for one pension fund each.

For most respondents the collateral is in the form of government bonds, followed by cash. Only one UK scheme said its collateral was "cash or stock".

Twelve pension funds have left the collateral unchanged since 2008 - in contrast to five that have changed it."We are in the process of implementing outsourced collateral handling with daily movements of collateral," said a Norwegian fund. A Dutch one added: "We started an interest rate swap overlay only recently."

Most respondents said that with higher quality in collateral to back swaps, haircuts had also generally increased over the past 12-24 months. "We have always only accepted government bonds and because of the market volatilities we have always used big haircuts in relation to the bonds' maturity time," explained a Danish fund.

The mood towards attempts to achieve central clearing of over-the-counter (OTC) derivatives, or even to bring OTC derivatives on-exchange, appears to be welcoming.

"We are looking forward to having central clearing. Such a situation will improve transparency and make risk management much easier, and this is a market need," said the Danish scheme. A UK fund said it was keen to see this happening but at the same time there was a need to ensure that the costs were not excessive. "[And we are] not sure how it would work for agent lending," it added.

Views varied in respect of the falling fees for custody services. "There comes a point when fees get too low and service suffers," said a UK fund. "Clients should be aware of that, but also custodians should be aware that clients are increasingly unwilling to pay unnecessary fees for ‘fat'."

"For further price reductions to work, the industry will need to automate more and [move] to real straight-throughprocessing," added a Norwegian scheme.